International Smaller Companies: Under the Radar.
Part 5 - Insight.
The value of an investment, and any income from it, can fall as well as rise and investors may not get back the amount invested.
Under the Radar
International Smaller Companies
Not helped by poor health, Maurits Cornelis Escher failed second grade and later dropped out of his studies. His passion was graphic design, but it took 30 years of graft to eventually make a living from it. His first major exhibition did not take place until he was 70 years old. Today, Escher’s works are globally recognised. Like many iconoclasts, his life is a tale of under-appreciated potential, but his work is a lesson in perspective. The segue into our investment approach is deliberately unsubtle.
Multi-stable perception is a pillar of Escher’s work. This is the phenomenon behind an optical illusion that causes our visual system to alternate between conflicting interpretations of an image. The conflict is unresolvable and ‘reality’ is in the eye of the beholder.
Neuroscience continues to be fascinated by this conflict, a deep curiosity which was first seriously researched by the polymath Hermann von Helmholtz in the 19th century. It arises because our minds yearn to construct a cohesive explanation about something which is, in truth, completely ambiguous. Sometimes we can see things both ways; we see the first image above as a vase but when we look hard we see the people. But, more interestingly, we often find ourselves completely fooled. Our minds are locked into just one interpretation, unable to even notice the alternative once it is pointed out to us. Some will be unable to see the old woman’s face instead of the hat-wearing woman. Stuck in their ruts, two minds can see exactly the same image yet be in fundamental disagreement. The same phenomenon applies to observations about companies, with interpretations and narratives about the future built from ambiguous inputs.
The role of insight within our framework is to remind us that a great business is not necessarily a good investment. The difference of course lies in whether its true potential is misinterpreted and therefore mispriced. Each buy or sell decision an investor takes implies a bold claim that they see the evidence in front of them about the future of the business in a way that the market does not. We think it is far better to be explicit about this key tenet of sound investing. Forcing ourselves to articulate “what the market may be missing and why the company might be undervalued” allows our claim of insight to be critically examined and instils a vital sense of humility.
The answer on insight is specific to each investment case, often hard to pinpoint and most likely an accumulation of small differences of view. But just as with the other spokes of the framework, certain companies in the portfolio stand out more than others. We think that Maytronics – the global leader in swimming pool cleaning robots – probably flies under the radar of many international investors because all of its written communications were, until recently, in Hebrew. There is no sell-side coverage of the business and we only really gained conviction in the investment case by visiting the Kibbutz Yizre’el near Tel-Aviv, the community in which Maytronics was founded in 1983 and where it remains based.
In the case of Sansan – a Japanese provider of digital business cards and a professional online network – there is a distinct probability that we see a radically different business than others do. Even before the coronavirus pandemic intervened in 2020, leasing scanners to digitise and store business cards hardly looked like a durable business model, let alone one to ignite the passion of growth investors with a universe of 25,000 companies to pick from. But we believe our interest in the software tools that Sansan is building around valuably volunteered data is differentiated. Our time horizon also allows us to envisage attempts to expand that core skillset into digitising contracts and invoices. Divergent perspectives on this, even within the team, offer a glimmer of what the market may be missing.
Each buy or sell decision an investor takes implies a bold claim that they see the evidence in front of them about the future of the business in a way that the market does not.
A longer term perspective
Although these are specific cases, an overarching theme in our approach is a belief in the power of perspective. We are certainly not arrogant enough to believe we are smarter, faster or working longer hours than others, but we do strongly believe that we often come at things differently. Underpinned by Baillie Gifford’s private partnership structure, the whole firm takes a long-term perspective which we believe can often produce insight. Under the right circumstances we are willing to take a leap of imagination into what might be, rather than merely staring intently at what is right in front of us.
A butcher looks at a cow and sees a quick buck from carving it into steaks. The milkman knows it is worth far more if he can just patiently accept the income over the years. But the entrepreneur sees organic yoghurt selling for $5 a tub in Whole Foods Market. Same cow (forgive me, I know modern agricultural genetics are somewhat more sophisticated!) but three very different perspectives. The latter involves a belief in an uncertain and far longer-term opportunity, which we think the market often struggles to fully value.
Take the case of Hypoport. This German software platform allows banks and credit unions to digitise the process of originating a mortgage, through an online marketplace that connects lenders and borrowers. The valuation has evolved with the success of the business and now prices in the potential for Hypoport’s market share to rise well beyond its current 30 per cent. But we are less sure the market is looking at Hypoport’s ongoing expansion into other financial services such as insurance and credit-broking, where a similar product and approach is sorely needed. Baillie Gifford’s experience of owning businesses that have successfully transitioned beyond their core competency helps us to look beyond the obvious. M3, for example, is a former small cap, owned since 2005, that started out as an online marketing platform for pharmaceutical companies but has parlayed its data and relationships into other ventures, from telemedicine to drug development. And when it comes to the decentralisation of responsibility that allows Hypoport to advance on different fronts simultaneously, colleagues’ research on established proponents of this approach, such as Atlas Copco (owned for over 30 years by some Baillie Gifford strategies), may be a meaningful advantage.
A second overarching theme we often think about is the potential for disguised value arising from intangible assets. Baillie Gifford has always emphasised the qualitative aspects of investing over the quantitative, one reason we recruit our investors from a diverse range of largely non-financial backgrounds. It’s highly likely that the market is efficient at copying down the numbers and incorporating past financial data into prices. We are far less sure it gives due credit to things such as company culture or the founder’s ambition which are far harder to capture with clear data.
There are countless examples in the portfolio of where such softer factors are a material part of the investment case, but a good one might be Reply. Superficially this is an unremarkable business (IT consultancy) in an unremarkable economy (Italy). However, on closer inspection, other often-ignored factors create a compelling investment case for the company. Reply has a strongly decentralised and entrepreneurial culture, overseen by eight of the nine founders (one having passed away) who continue to work in the business as well as owning half of it. Our work suggests such factors continue to be overlooked and the beginnings of its international expansion suggests there is still plenty of potential for the future.
What ties the two previous differences of perspective together is a willingness to place value on aspects that are contingent and ambiguous, such as an opinion on a CEO or the possible adjacent markets a business can expand into. Investing on the basis of such factors is hard to do and needs the right philosophy and process as well as the support of a collegiate firm with a long-term time horizon. Baillie Gifford is such a firm. ‘Reality’ is in the eye of the beholder, so colleagues need to trust you while your views are unprovable, whilst also challenging you to consider alternative interpretations. Our process supports individual conviction and enthusiasm. You need to be allowed to invest with the patience that allows such things to matter. We support each other, and the companies in which we invest, over the bumps in the road.
A great business is not the same as a good investment. Every investment decision carries a claim of insight about something the market is missing. You are only likely to discover that if you are willing to look at things differently. As active, bottom-up stock pickers with a long-term time horizon, we appear to be an increasingly rare breed. We also work in a firm with understanding colleagues and we hope, in time, supportive clients. This all adds up to a different approach which accepts uncertainty and values possibility. Escher eventually found fame by celebrating the ambiguities of perspective. We are merely hoping to use them to find great investment returns.
The views expressed in this article are those of the International Smaller Companies team and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in March 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
Potential for Profit and Loss
All investment strategies have the potential for profit and loss, your or your clients’ capital may be at risk. Past performance is not a guide to future returns.
Any stock examples and images used in this article are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.
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